Investors Scrutinizing the Regulators

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March 2008
IMF points a finger at weak Canadian securities regulation
The IMF’s report homes in on lax enforcement, and also calls for a national securities regulator


By James Langton

Many who work in the Canadian securities industry and have the pleasure of dealing with the regulatory system find it needlessly complex and weak when it comes to enforcing the rules. They now have some independent validation for that view, as a recent report from the International Monetary Fund echoes those concerns.

The IMF published three reports in mid-February detailing the results of its latest assessment of the stability of the Canadian financial services sector. Along with the overall report on the sector’s soundness, it also issued more detailed reports regarding the level of compliance with the International Organization of Securities Commissions’ principles of securities regulation, and its recommendations for securities settlement systems.

On the banking side, it found that the Canadian sector is generally sound and stable and apparently able to accommodate “sizable shocks.” It did, however, point out a couple of areas in which the banks could face challenges — namely, breaking into highly competitive foreign markets in pursuit of growth and the risks inherent in structured products that have recently been exposed by the credit-market disruption. Indeed, its high priority recommendations generally involve improving risk assessment and monitoring fallout from the credit crunch.

However, the IMF also delved into the securities regulatory system, echoing the chief complaints of many in the Canadian securities industry regarding regulation. On most counts, it found the Canadian system in compliance with IOSCO principles, but it also singles out several areas for improvement — and calls for the adoption of a single regulator.

Indeed, for evidence that the IMF finds the Canadian system unwieldy, look no further than the fact that, although its review purports to assess the domestic regulatory system, it bases its judgment only on the situation in Ontario and Quebec — saying that the task of reviewing every province would be “impossible” and that focusing on two of the big jurisdictions represents a reasonable approach.

The report notes that the creation of the umbrella group for provincial regulators, the Canadian Securities Administrators, marks an improvement on the existing fragmented system, as does the adoption of the passport system. But, the report adds, “Even so, moving further to a single regulator would allow policy development to be streamlined, reduce compliance costs and improve enforcement.” All of which are familiar arguments by proponents of a single regulator.

The two areas in which the IMF finds the biggest weaknesses are enforcement and the regulation of “collective investment schemes,” as they are known in the international arena (mutual funds and other investment funds).

The report concludes that there are “gaps in the regulation and supervision” of investment funds. As it points out, the fact that fund managers aren’t yet subject to a registration regime means that the regulators can’t impose minimum standards. “It is questionable whether they have full disciplinary authority over them,” the report adds. It also notes that some funds are not required to have a custodian.

These regulatory gaps can hardly come as news to anyone who has worked in the industry since the mid-1990s, which is when then-commissioner of the Ontario Securities Commission, Glorianne Stromberg, produced a report highlighting many of these same issues.

That said, many of its complaints, the IMF report points out, will be addressed by the CSA’s proposed registration reform. This would, among other things, require fund manager registration, thereby imposing conditions such as proficiency requirements, capital and insurance standards and conflict of interest guidelines. (The custodian requirements will be imposed by a different rule.)

The IMF indicates that it was told the regulators expect the registration reform to be adopted by July 1. Whether the CSA meets this deadline remains to be seen.

When the proposed reform was originally published for comment in February 2007, regulators said that they intended to have it implemented by the end of 2007. After it became clear that material revisions were necessary, they promised to republish the rule by the end of this past year. However, that has yet to happen.

Now, regulators are planning to publish the rule for another comment period on Feb. 29 (after Investment Executive’s deadline). This time, it’s expected to go out for a 90-day comment period, not the 120-day period it had the first time around. Even so, assuming that the rule is published as expected, the comment period would finish at the end of May — giving regulators just one month to finalize it by July 1. That seems unlikely.

In addition to the gaps that would be addressed by registration reform, the IMF also notes that the Autorité des marchés financiers currently doesn’t include mutual funds or fund managers as part of its regular oversight reviews. It recommends that the AMF add funds to its regular inspection regime, and that the government in Quebec also consider bringing mutual fund dealers under securities legislation.

The other big area that needs improvement, according to the IMF report, is enforcement. Again, this is a familiar complaint to industry veterans — as are the claims from regulators that they are improving things. The IMF acknowledges that there has been progress toward better enforcement. But “it is still in need of considerable improvement,” the report says.

Of course, there’s no silver bullet to instantly improve enforcement. The implementation date for registration reform seems highly optimistic. But, at least, when those measures are adopted, they should certainly close many of the gaps in fund oversight. No similar quick fix is on hand for enforcement, nor does the IMF propose one.

The IMF does call for regulators to speed up their investigations. And it specifically points to the need for better integration between regulatory and criminal enforcement activities. The report characterizes criminal enforcement efforts as “particularly weak,” noting that “the development of a co-ordinated approach to enforcement between criminal and securities law enforcement, with clear lines of accountability and benchmarks, seems to be missing.”

Additionally, the IMF report suggests there are weaknesses in the provincial regulators’ oversight of self-regulatory organizations. In particular, it indicates that the AMF has suffered from staff shortages that have impeded its ability to oversee the SROs operating in that province. As a result, it suggests that more co-ordination is needed in the area of SRO oversight, including the approval process for regulations. It also says that the regulators’ SRO reviews should be more frequent.

Along with the recommendations in the areas of enforcement, investment funds and SROs, the IMF report includes a host of other suggestions concerning everything from derivatives regulation to government debt market transparency. It notes that regulators largely agree with its assessment. The question is whether they have the will or ability to make the improvements that are needed to bring the Canadian regulatory system into full compliance with IOSCO principles. IE